When compounding interest in a taxable environment, one must pay taxes annually on the growth of the account. These taxes are most often paid from current income (a.k.a. lifestyle), thus generating an often overlooked "hidden contribution" to support the taxable account balance. You may display the effect of opportunity cost on the main compound interest screen by clicking the [Show Opp Cost] button. This button will toggle the display between "regular costs" and "opportunity costs". |
Let's go through the years slowly watching the account grow on the left, which represents the money you have in your account. The account on the right represents the taxes which you must pay in order to maintain the account on the left. What is your first reaction to seeing this happening to your account? Where are you getting the money to pay the taxes due each year on the earnings in your investment account? (current income or lifestyle) If I can show you some opportunities which would allow you to avoid transferring those taxes to the government each year it would have a dramatic impact on your Circle of Wealth. This screen is not the whole picture because we have not even considered the opportunity cost. |
The year-by-year values are calculated using a worksheet with the following columns: Column 1 is the year. Column 2 is the annual deposit made at the beginning of each year. It may be zero if no deposit is made. Column 3 is the balance at the beginning of the year. Column 4 is the interest earned during the year (Column 3 * Investment Rate of Return). Column 5 is the balance at end of the year. It is the balance at begin of year plus the interest earned during the year. Column 6 is the cumulative interest. It is accumulating (summing) the interest displayed in column 4. Column 7 is the tax paid at the end of the year. It is the tax bracket times the interest earned during the year. For example, if the tax bracket is 31% and the interest earned is $1,000, the tax would be $310. Column 8 is the cumulative tax paid. It is accumulating the taxes displayed in column 7. Column 9 is the Balance at the End of the Year minus the cumulative tax. This is column 5 minus column 8. Column 10 is the Cumulative Opportunity Cost of Taxes as of the current year. It is calculated using the equation: Cumulative Opportunity Cost of Taxes = taxes for current year plus (1 + Net Opportunity Interest Rate) x (cumulative opportunity cost of taxes as of the previous year) Column 11 is the Balance at the End of the Year minus the cumulative Opportunity Cost of Taxes. This is column 5 minus column 10. For simplicity, annual compounding is used on this hypothetical example. Net Opportunity Interest Rate = Investment Rate of Return * (1 - Assumed Tax Bracket). |